The new Flat Rate VAT Scheme: What does it mean for the self-employed?

January 11, 2017

Flat Rate VAT schemes may not be the first thing on everyone’s mind after Christmas however following Chancellor Philip Hammond’s Autumn Statement this year, you may want to take a closer look if you’re a VAT registered small business or a contractor.

What is VAT?

VAT is a tax paid on most goods and services. VAT registered firms have to charge VAT on their sales and can reclaim VAT on their purchases. This involves careful record-keeping of all transactions and the rate of VAT they were charged at.

So what is the Flat Rate VAT scheme?

To reduce the burden of this record-keeping on smaller firms, HMRC offers a Flat Rate scheme. With this scheme, rather than having to pay HMRC what you’ve collected in VAT on your sales less the VAT you’ve claimed for on expenses, you simply need to pay HMRC a set percentage of your sales. This means small firms generally don’t need to track VAT on purchases.

Why is it changing?

The growing numbers of self-employed were directly cited by the Chancellor as a cause for declining tax revenues, however our experience and research shows that people incorporate for commercial reasons, not tax. The Chancellor clearly thought these VAT schemes were too generous and too many firms were using them. So, on top of the dividend tax hike earlier this year, we now have a VAT change.

How will Flat Rate VAT change?

From April 2017, the Government is introducing a new 16.5% Flat Rate VAT scheme that many ‘labour-only’ businesses, such as contractors, will have to move to. This will reduce some of the benefits of Flat Rate VAT for many self-employed firms, but it will still be more cost-effective than not being in the scheme.

Due to the way the Flat Rate scheme rates are set (e.g. 14% for business consultants), if you’re caught by the new rules you’ll end up paying more VAT (so a business consultant would pay an extra 2.5% of VAT).

Who exactly will this apply to?

A definition has been created of ‘limited cost traders’ who count as ‘labour-only’ businesses that will have to use the 16.5% rate if they want to use the Flat Rate scheme.

A limited cost trader is defined as one that spends less than 2% of its sales on goods (not services) in an accounting period.

When working out the amount spent on goods, it cannot include purchases of:

  • capital goods (such as new equipment used in a business)
  • food and drink (such as lunches for staff)
  • vehicles or parts for vehicles (unless running a vehicle hiring business)

If a firm spends less than £1,000 in their accounting period (that’s HMRC speak for the period you produce your annual accounts for), they also count as ‘labour-only’ even if this is more than the 2%. If your accounting period is longer / shorter than 12 months, the £1,000 threshold is pro-rated.

What should I do if I’m already on the Flat Rate scheme?

You should carefully compare your trading activity and costs against the definitions published by the Government. We await HMRC’s further guidance on this and will post further updates. In the meantime you should consider setting aside funds to address any increase in your Flat Rate scheme level.

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